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Finding diversification in a correlated world

September 2016

The actions of central banks have helped fuel returns since the end of the financial crisis and increased correlations between assets. Diversification may not seem so important in a world of rising asset prices, but its virtues will become all too apparent when the market turns.

With unprecedented monetary policy easing by the world’s major central banks since the end of the financial crisis driving interest rates to record lows, the price of pretty much everything other than commodities and deposit accounts – from sovereign debt to emerging-market equities to fine wine – has climbed sharply.

With interest rates at near zero, or in many countries below zero, if they do begin to rise investors are likely to face an altogether harder challenge generating attractive performance. This is compounded by the extent to which correlations between asset prices have risen. Falling interest rates have helped push asset prices higher in lockstep. An increase in correlations is fine as long as prices keep rising, but there is an obvious danger rising rates will have the opposite effect. Which begs the question: how can investors diversify their portfolios?

The two heat maps below give a visual indication of the extent to which correlations between various international equity markets have risen in the past eight years when compared with the 15-year period that preceded the financial crisis. In the tables, red indicates a strong positive correlation, orange a weaker one, and yellow a weaker one still. The correlation between the six indices averaged 0.64 in the years leading up to the financial crisis and 0.79 since.

Interestingly, while many investment assets have risen in price since the onset of the financial crisis, they’ve not always done so simultaneously. Take US equities and government bonds. As the chart below shows, the correlation between the two has actually got steadily more negative over the past 20 years. Furthermore, there have been many periods since the crisis when the correlation has been below the 20-year average. So although government bonds have also rallied over the last eight years, they’ve actually provided one of the few means of diversifying a portfolio of shares, or ‘risky’ assets.

The apparent incongruity of an increasingly inverse relationship between the prices of US stocks and Treasuries, which have nevertheless both risen, is explained by the fact that while monetary easing has driven financial asset prices higher simultaneously for much of the past seven years, there have also been lengthy periods when this has not been the case. During such moments, market sentiment has gyrated wildly with optimism interspersed with bouts of extreme pessimism as investors questioned central banks’ ability to reignite economic growth.

In market parlance, a pronounced ‘risk on, risk off’ (RORO) environment has prevailed during these moments with investors tending to behave in a herd-like manner; at times clamouring for ‘safe havens’ such as government bonds only to suddenly switch back into risky assets once the panic has subsided.

This is making it increasingly difficult to ensure portfolios are sufficiently diverse. For a start, it is becoming ever harder to predict the correlation between ‘risk’ and ‘safe-haven’ assets, as illustrated by what happened to the US dollar late last year. After a prolonged period where the dollar acted as a safe-haven asset, this changed dramatically in December, when sharp falls in risk assets were accompanied by a sizeable decline in the dollar against both the euro and yen. Whereas previously a ‘long’ position in the dollar would have provided downside protection to a portfolio of risky assets, suddenly at the start of this year it would have exacerbated losses.

More fundamentally, even if investors can correctly pick out safe-haven and risk assets that will continue to be negatively correlated, positions in the two don’t represent independent sources of risks. Both are really just opposing legs of the RORO trade. The main driver of the performance of a portfolio or investment strategy is simply whether the correct call was made on being net long or short risk. Individual asset class or regional idiosyncrasies are of lesser importance.

As for those periods when the actions of central banks are dominant, pretty much all assets move in the same direction. That may not be so much of a problem in the current environment. But it begs the obvious question: where will investors get the diversification they need when interest rates are rising?

The answer lies partly in being as prepared as possible for the unexpected. Although the future is full of uncertainty, that doesn’t mean investors can’t take steps to prepare for it. This requires analysis of how financial markets would be likely to respond to a range of hypothetical scenarios, and building portfolios that at least stand a chance of coping with the most extreme of them.

As an example, you may believe that inflation will remain subdued over the medium term and wish to build a portfolio accordingly. But it would probably be sensible to assess how that portfolio would perform in the event your forecasts proved inaccurate and inflation began to take root. That may cause you to adjust your investments, with the size of adjustment depending on how much uncertainty surrounded your forecast. It would probably also be wise to make more allowance than previously for the possibility that correlations may change – potentially quite suddenly – as was seen with the dollar and risk assets earlier this year.

This, together with the fact there maybe fewer assets capable of offering diversification, means it is advantageous to have the biggest tool kit possible. For example, since shifts in market sentiment are likely to coincide with big spikes in volatility, positions in derivative contracts that profit from rising volatility are obvious ways to diversify risk. The asymmetric return profile offered by options means they can be another useful way of taking out insurance. And establishing a combination of short and long positions is another means of boosting diversification, while investors could also broaden the range of assets in which they look to invest. Rather than considering just government bonds as diversifiers, they should consider whether a mix of assets would provide more protection.

It seems likely that financial markets will struggle to adjust when central banks decisively reverse course given the enormous scale of the intervention seen in recent years. But that doesn’t mean investors need to get caught in the headlights. Preparation is key to ensuring that portfolios are built to be sufficiently diverse and able to withstand the challenging period ahead.

Important Information

This document is for professional clients, financial advisers and institutional or qualified investors only. Not to be distributed, or relied on by retail clients.

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 21 September 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.